CHAPTER 7

Interest Rates

Determinants of interest
rates
The term structure and
yield curves
Investing overseas

6-1

What four factors affect the

level of interest rates?

Production
opportunities
Time preferences
for consumption
Risk
Expected inflation

6-2

Nominal vs. Real rates

r

= represents any nominal rate

r*

= represents the real risk-free

rate of interest. Like a T-bill rate,
if there was no inflation. Typically
ranges from 1% to 4% per year.

rRF

= represents the rate of interest

on Treasury securities.
6-3

Determinants of interest
rates
r = r* + IP + DRP + LP + MRP
r
= required return on a debt security
r* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP= maturity risk premium
6-4

Premiums added to r* for

different types of debt
IP
S-T Treasury
L-T Treasury
S-T
Corporate
L-T
Corporate

MR DRP LP
P

6-5

Yield curve and the term

structure of interest rates

Term structure
relationship
between interest
rates (or yields)
and maturities.
The yield curve is a
graph of the term
structure.
The November
2005 Treasury
yield curve is
shown at the right.
6-6

Constructing the yield curve:

Inflation

Step 1 Find the average expected

inflation rate over years 1 to N:
N

IPN

INFL

t 1

6-7

Constructing the yield curve:

Inflation
Assume inflation is expected to be 5% next
year, 6% the following year, and 8% thereafter.
IP1 = 5% / 1 = 5.00%
IP10= [5% + 6% + 8%(8)] / 10 = 7.50%
IP20= [5% + 6% + 8%(18)] / 20 = 7.75%
Must earn these IPs to break even vs. inflation;
these IPs would permit you to earn r* (before
taxes).
6-8

Constructing the yield curve:

Maturity Risk

Step 2 Find the appropriate

maturity risk premium (MRP). For
this example, the following equation
will be used find a securitys
appropriate maturity risk premium.

MRPt 0.1% ( t - 1 )

6-9

Constructing the yield curve:

Maturity Risk
Using the given equation:
MRP1 = 0.1% x (1-1) = 0.0%
MRP10 = 0.1% x (10-1) = 0.9%
MRP20 = 0.1% x (20-1) = 1.9%
Notice that since the equation is
linear, the maturity risk premium is
increasing as the time to maturity
increases, as it should be.
6-10

Add the IPs and MRPs to r* to

find the appropriate nominal
rates

Step 3 Adding the premiums to r*.

rRF, t = r* + IPt + MRPt
Assume r* = 3%,
rRF, 1 = 3% + 5.0% + 0.0% = 8.0%
rRF, 10 = 3% + 7.5% + 0.9% = 11.4%
rRF, 20 = 3% + 7.75% + 1.9% = 12.65%
6-11

Hypothetical yield curve

Interest
Rate (%)
15

10

Maturity risk premium

Inflation premium

5
Real risk-free rate

0
1

An upward
sloping yield
curve.
Upward slope due
to an increase in
expected inflation
and increasing
maturity risk
premium.
Years to

10

20 Maturity

6-12

What is the relationship between

the Treasury yield curve and the
yield curves for corporate issues?
Corporate yield curves are higher
than that of Treasury securities,
though not necessarily parallel to
the Treasury curve.
The spread between corporate and
Treasury yield curves widens as the
corporate bond rating decreases.
6-13

Illustrating the relationship

between corporate and Treasury
yield curves
Interest
Rate (%)
15

BB-Rated
10

AAA-Rated

Treasury
6.0% Yield Curve

5.9%

5.2%

Years to

0
0

10

15

20

Maturity
6-14

Pure Expectations
Hypothesis

The PEH contends that the shape of

the yield curve depends on investors
expectations about future interest
rates.
If interest rates are expected to
increase, L-T rates will be higher than
S-T rates, and vice-versa. Thus, the
yield curve can slope up, down, or
even bow.
6-15

Assumptions of the PEH

Assumes that the maturity risk

premium for Treasury securities is
zero.
Long-term rates are an average of
current and future short-term rates.
If PEH is correct, you can use the
yield curve to back out expected
future interest rates.
6-16

An example:
Observed Treasury rates and the
PEH
Maturity Yield
1
2
3
4
5

year
years
years
years
years

6.0%
6.2%
6.4%
6.5%
6.5%

If PEH holds, what does the market expect

will be the interest rate on one-year
securities, one year from now? Three-year
securities, two years from now?
6-17

One-year forward rate

6.0%
0

x%
1

6.2%

(1.062)2 = (1.060) (1+x)

1.12784/1.060 = (1+x)
6.4004% = x

PEH says that one-year securities will yield

6.4004%, one year from now.
Notice, if an arithmetic average is used, the
answer is still very close. Solve: 6.2% = (6.0%
+ x)/2, and the result will be 6.4%.
6-18

Three-year security, two years

from now
6.2%
0
5

x%
2

6.5%

(1.065)5 = (1.062)2 (1+x)3

1.37009/1.12784 = (1+x)3
6.7005% = x

PEH says that three-year securities will yield

6.7005%, two years from now.
6-19

Conclusions about PEH

Some would argue that the MRP

0, and hence the PEH is incorrect.
Most evidence supports the
general view that lenders prefer ST securities, and view L-T securities
as riskier.

Thus, investors demand a premium to

persuade them to hold L-T securities
(i.e., MRP > 0).
6-20

Other factors that influence

interest rate levels

Federal reserve policy

Federal budget surplus or deficit
Level of business activity
International factors

6-21

Risks associated with

investing overseas

Exchange rate risk If an

investment is denominated
in a currency other than U.S.
dollars, the investments
value will depend on what
happens to exchange rates.
Country risk Arises from
investing or doing business
in a particular country and
depends on the countrys
economic, political, and
social environment.
6-22

Country risk rankings

Top 5 countries (least risk)
Ran Country
k

Score

Bottom 5 countries (most

risk)
Score
11.0

Switzerland

95.2

Ran Country
k

Luxembourg

93.9

169 Afghanistan

United States

93.7

170 Liberia

9.4

Norway

93.7

171 Sierra Leone

9.3

172 North Korea

United
93.6
Kingdom
173 Somalia
Source: Country Ratings by Region, Institutional
Investor, www.institutionalinvestor.com, September
2004.
5

8.9
8.2
6-23